'Technical' factors drive banks back to profit

Major US and European banks are predicting profits for the first quarter of 2009 - but analysts caution that the apparent upturn has more to do with technical factors than a real recovery in performance.

Bank of America, Citi, Credit Suisse, JP Morgan, and Deutsche Bank have all predicted profits in Q1 2009 - and analysts expect that Barclays, BNP Paribas, Goldman Sachs, HSBC and Morgan Stanley could also finish March in the black.

Some senior figures in the banking industry have credited improved market conditions for the bullish forecasts. BoA's chief executive Ken Lewis told the Boston Chief Executives' Club on March 12 that "the industry is not nearly as dire as it seems", saying that BoA could generate a pre-tax and pre-provision profit of "close to $50 billion" this year, and had already made a profit in the first two months.

Jason Goldberg, New York-based managing director of equity research at Barclays Capital, said: "In Q1 we expect remarkably improved capital markets related results, and a reversal of the pressures in Q4, as well as mortgage refinance activity. In addition, tight cost controls should offset continued loan-loss provisioning and writedowns". In any case, the worst of the writedowns are probably now past, added Anthony Polini, an equity analyst at Raymond James in New York.

But Jon Peace, London-based equity analyst at Nomura, cautioned that technical anomalies were helping to drive profits. "We are seeing a combination of some genuine signs of activity, such as good performance from rates and foreign exchange businesses and high-grade debt issuance, with a number of one-off positive factors", he noted. Two factors - a reversal of basis risk on debt hedging, and an accounting gain on the valuation of the banks' own debt - "will dwarf the growth in underlying acceleration in real activity", he said.

Another London-based bank analyst noted: "This is not client-driven business as usual... It is more of a technical factor." In Q4, banks' bond holdings saw a breakdown in the link between cash and credit default swap (CDS) spreads, he said. CDS hedges which had worked well in the past broke down as cash spreads widened far faster than CDS spreads, and the banks, whose hedges made them effectively long cash bonds and short CDSs, took heavy losses.

Banks will also see one-off gains this quarter on holdings of their own debt: Q4 2008 saw bank CDS spreads remain narrow while their counterparties' spreads widened, leaving the banks with heavy losses. But so far this year the reverse has happened, and wider bank CDS spreads have increased the accounting value of their own debt, producing large book profits.

In early March, Vikram Pandit, chief executive of Citi, told employees that the bank was having its best quarter since Q3 2007, and was 'profitable' in the first two months of 2009, with revenues of $19 billion. He attributed this growth to the strong performance of client businesses, securities and banking operations, as well as the sale of its Smith Barney brokerage business to Morgan Stanley, and the conversion of mandatory convertibles that were expected to add another $14 billion to the firm.